Does This Struggling Retailer Have Hidden Real Estate Value?

There's a battle going on over the worth of Sears Holdings Some, like famed investor Bruce Berkowitz of Fairholme Capital, believe that unrecognized real estate values offer meaningful share upside. Others hold a differing view. Sears doubters, like Credit Suisse analyst Gary Balter, are skeptical that any meaningful wealth will be delivered via real estate. Instead, they note the company's money-losing retail operations and figure the shares are priced too high as it is.

Should the shares be trading higher or lower? Let's take a look and see if there's a way to profit from this conflict.

How to Value SearsThe gist of the Sears Holdings' bullish view rests on the value of its properties. But what are those locations, mostly held under the Sears and Kmart brand, really worth? While comparable real estate sales transaction values are available, they might not be truly representative of how the company's stock should trade. For example, the chance that the company could unload a meaningful amount of property in a timely matter is slim. Such a liquidation could take many years, which would mean any current property market values would have to be severely discounted to describe a fair share price.

An alternative method of calculating Sears' real estate value is on an operating basis. This method first finds the current enterprise value, stock market value plus financial obligations, of comparable retailers. It then translates that amount into a square foot real estate estimate. Those competitive comparisons can then be used to judge where Sears' stock could trade on a similar operating real estate value basis.

Some Competitor BenchmarksA couple of good Sears Holdings comparisons might be Target for the better located Sears brand locations and Big Lots for the less desirable Kmart brand properties.

These retailers both have well respected and well run retail operations. Armed with ample cash flows, they will likely be valued on the high end of what retailers could be worth on an operating real estate value basis.

Target currently runs more than 1,800 stores. Its shares look to be trading at close to fair value, near the Thompson/ First Call median analyst target. With a current stock market value around $40 billion and including operating lease and debt obligations of around $23.7 billion, it has an enterprise value of around $63.7 billion. This equates to roughly $267 per square foot given its 237.8 million square feet of space.

Since the company has an accomplished and profitable retail business, the $267 per square foot value looks to be the most a Sears brand location might be worth.

Big Lots is North America's largest closeout retailer. It currently has a market capitalization of around $2.0 billion with operating lease and debt obligations of around $1.5 billion for a total enterprise value of around $3.5 billion. This equates to roughly $77 per square foot on a total of 45.0 million U.S.-based square feet.

Its shares also look like they're trading relatively fairly based on median analyst estimates. So Big Lots $77 per square foot value appears a credible ceiling for what a Sears' Kmart property might fetch.

Now that we have some reasonable high-end estimates, what about a low-end take? Beleaguered J.C. Penney might be a helpful comparison for Sears brand locations in that regard.

J.C. Penney's management travails have been well publicized and many believe that the company has a good chance of going under. Not surprising when the company continues to post results like the stunning 11.9% drop in total and comparable-store sales in its latest quarter.

Given that J.C. Penney's has a market capitalization of about $2.8 billion with financial obligations of around $7.6 billion, it has a total enterprise value of roughly $93 per square foot on its 111.6 million square feet of property. This figure looks a reasonable floor on what a Sears brand location is worth given the possibility of a J.S. Penney's bankruptcy.

An Estimate of Sears' Real Estate ValueWith some high-end comparisons provided by Target and Big Lots and a low-end take from J.C. Penney, our calculation of a similar Sears' estimate might look something like this:

Estimated Value of Sears' Real Estate

Square feet

Est. value per ft.

Value

Sears brand locations

108.3 mm

$130

$14.1 billion

Kmart brand locations

116.6 mm

$40

$4.7 billion

Less financial obligations

($6.7 billion)

Total net real estate value

$12.1 billion

Net value per share

$114

Source: Sears Holdings 2012 SEC 10-K filing

Given the peer evidence, a $130 per square foot value seems a reasonable middle ground for the Sears brand locations and the $40 per square foot estimate for Kmart properties seems to look fair. If anything, erring on the low side is preferable to judging too optimistically.

It's Retail Worries That Hinder the Share PriceThe major obstacle to Sears trading nearer its estimated $114 operating real estate value seems to be worries about the retail business. Comparable-store sales have been sinking over the last three years. Domestic comps fell 2.2% in 2011, 2.5% in 2012 and a like 2.5% in the first six months of 2013.

Sears operating-cash-flow losses over the past couple of years only increases the anxiety. With the flow worsening over the first six months of 2013, a lack of shareholder enthusiasm seems justified.

If the cash flow deficits cannot be stymied, investors might be fearful that Sears Holdings real estate value could fall substantially. As J.C. Penney shows, serious store losses can significantly undermine property values. But as Target and Big Lots demonstrate, good retail results can also help to increase the worth of underlying real estate.

ConclusionThe clash over Sears Holdings has been fierce. It seems that, one way or the other, its shares will ultimately trade either significantly higher or meaningfully lower than the current bid. The direction likely being dependent on whether retail operations improve or deteriorate.

The risks involved in such a "win or lose" situation are usually too high for the ordinary investor to undertake. The best course of action, at the moment, might be to just wait and watch for a sign that Sears' retail business is at least stabilizing. This indication could be the catalyst for a higher stock price while reducing downside risk. Though the strategy doesn't sound very exciting, it is the one that I'm following and may be the safest way to profit from the battle over where Sear's true value lies.

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